Question

3- Explain the impact on the following events on the money market equilibrium and equilibrium interest rates. (25 pts):

a) Real GDP increases due to an increase in exports (12.5 pts)

b) Central bank sells government bonds in the private financial markets. (12.5 pts)

Answer 1

In following graphs, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0.

(a)

Increase in real GDP increases price level, which decraeses purchasing power, which in turn increases the demand for money. The money demand curve shifts rightward, increasing interest rate.

In following graph, hen money demand increases, MD0 shifts right to MD1, intersecting MS0 at point B with higher interest rate r1.

(b)

Central bank's open market sale will lower the money supply. Decrease in money supply shifts money supply curve leftward, increasing domestic interest rate and decreasing the quantity of money.

In following graph, decrease in money supply causes MS0 to shift left to MS1, which intersects MD0 at point B with higher interest rate r1 and lower quantity of money M1.